11 SEP


Opinions , Tristan Abet

Goods vs services

Donal Trump has proven to be a different type of president. His policies, which have no real precedent in recent US history other than his highly direct communication methods, can be resumed as follows: 1) policies based on economic patriotism and 2) stimulus policies despite an overheating economy.

In the globalised world where corporate logic has no borders, promoting domestic production is a surprising move. What is the rationale behind this strategy? Is there even a strategy, or is it simply an ideology?

Economists, the vast majority of whom are neoliberals (see our June 2017 paper on this topic) are unanimous in rejecting protectionism, claiming that this type of policy is doomed to fail and that there will only be losers. This is one of the facets of the new Washington consensus, which believes that globalisation is good and that all markets must be liberalised as the most efficient method of generating sustainable growth.

In the real world however, the efficiency of liberalisation at any price remains to be proven. There are many nuances. This is particularly evident in Europe where eurozone countries have tried to establish an optimal area from an economic point of view by creating a single currency and scrapping cross-border frictions. However, 20 years later, the result is not very impressive. Foreign trade dynamics are only part of the highly-complex economic growth equation.

Before developing this point, let us reflect briefly on the second component of Donald Trump’s unconventional policies, involving a stimulus plan at the top-end of the cycle. This is an interesting topic at a time when certain observers are concerned over the sustainability of Italian and Japanese debt. Under the IMF’s cyclically-adjusted methodology, it is clear that the US will post the heaviest budgetary deficit out of the G4 this year while the eurozone will record the lowest deficit, despite perhaps having greater need of a heavier negative budget balance (-5.6% vs -0.8%).

This is an economic policy choice. It will be interesting however to observe budgetary deficit dynamics when growth slows down. This is a similar situation to the ECB maintaining European rates at all-time lows while the European economy is no longer in a distressed situation. What will happen to these policies during the next economic downturn?

As this question is not the main subject of this analysis, we shall therefore return to Donald Trump’s America First policy. We suspect that he may have looked at the chart below which reflects the US trade balance in goods & services over 12 months as a percentage of GDP since 1996.

We should remind our younger readers that the early 2000s were relatively monothematic. After the 2001 recession, economists spoke solely of the jobless recovery then, once the economy began to recreate jobs at the end of 2003, they focused on the US twin deficit. This dual deficit, including a fiscal deficit and a current account deficit was considered to be a major risk for the global economy, as reflected in the rhetoric over global imbalances.

The above chart demonstrates that the balance of goods excluding oil remains in deep deficit whereas the balance of services has improved and US dependence on oil imports is now close to zero. The trade balance with OPEC countries turned positive in 2016 and is posting only a slight deficit in 2018.

Although today’s situation is therefore worse than in the early 2000s no one mentions this, as economists have absorbed this fact and moved-on to the latest “the trade war is bad” theme.

The relentless rise in the S&P500 shows that there are investors who believe that the trade war will not weigh on US companies. The bullish trend in US equities relative to the rest of the world is sending out a clear message: the context of higher customs tariffs is potentially good news for the US. How is this possible?

The answer lies in the previous chart. The S&P500 reflects the fact that services, which dominate the broader US economy, are not concerned by customs tariffs. It is as simple as that. Inversely, European and emerging indices have a much heavier goods weighting and goods will be taxed. It is hard to criticise Donald Trump’s protectionist policy from a US point of view as the US is a net buyer of goods and a net seller of services. In other terms, the US is a client for goods and wishes to renegotiate relations with its suppliers whereas on the other hand, it does not intend to review its relations with its clients when it is a supplier (of services). Perhaps this approach is not simply ideological, it is certainly pragmatic.

It is of course a complicated subject. There is no binary issue, whereby one solution works and the alternative fails.

Furthermore, we believe that the most surprising factor is the European incapacity to react and adopt a similar Europe First policy. The S&P500 is bullish on account of a surge in profits (+24% YoY expected for 2018 vs +8.3% YoY sales growth) underpinned by a robust domestic cycle, tax cuts, currency impact and the colonisation of the rest of the world, notably Europe. During Q2, Google increased sales in the US by 21% and by 26% in Europe. Facebook published similar figures, with +37% US vs +47% Europe, along with Pfizer which posted -2% US vs +10% Europe. Although Donald Trump is criticised by many commentators in Europe, it is clear that if Europe defended European companies as fiercely as the US defends its domestic companies, European equities would have delivered a much strong relative performance.

The US sector performance chart below illustrates this situation. Services sectors are at their highs, whereas goods sectors have been weighed down by the trade war risk premium.

The divergent performances between country indices are attributable to the fact that the S&P500 is more heavily weighted in services companies, whereas the Eurostoxx is more heavily weighted in goods companies.

Donald Trump’s trade war is therefore clearly a way of attacking the rest of the world’s leadership in terms of goods production without weighing on the US leadership in services.

What can interrupt this scenario? The dollar may be the answer. Donald Trump complains about trading partners manipulating their currencies, as a strong dollar reduces the impact of his policy. These 2 factors are indivisible however. It is not possible to trigger a positive growth shock and expect currency depreciation at the same time. The strong dollar is simply the corollary of an overstimulated economy. As divergence in growth with the rest of the world increases, the dollar will be become increasingly stronger. The current situation is notably similar to the scenario at end of the 90s.

The dollar should therefore act as an economic stabiliser. Financial markets will indicate the level at which the pain threshold has been reached as, unfortunately, this is only perceivable once the harm has been done. Have we come that far yet? Everyone will form their own opinion.